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    Saturday, January 08, 2011


    Purchasing Power Parity Valuation for the Australian Dollar 2011

    I first wrote about the Australian Dollar PPP in October 2008. The AUDUSD had fallen to .62 on it’s way to .61 a couple of days later and was 40% undervalued (all over/under valuation is compared to USD). The crux of the October 08 post was to invest in AUD assets at that time because there was a substantial headwind in other currencies if your base is in AUD. Similarly in other currencies you had the chance to be buoyed by AUD appreciation. The work was based on the Economist Big Mac index. There is substantial research that a few simple metrics often out perform larger models and Purchasing Power Parity (PPP), the idea that representative goods should trade at similar prices world wide, makes sense. There was a belief in Australia, in late 2008, that the AUD was going to keep falling. I had dinner around Christmas in 2008 and discussed this with an IT company CEO and a senior manager at an international oil company. They both thought an appreciation of the AUD was quite unlikely; they were wrong and PPP was right.

    Where are we now

    John Hempton of Bronte Capital, a blog I strongly recommend, has noted “And early is wrong. At least if you are an Australian and you took your cash offshore at 80c or less to the USD.”. Today the AUDUSD is 1.0 with a high of 1.03 reached recently.

    The October 2008 list of major countries who’s currencies were more undervalued than Australia’s was;

    Now It’s somewhat larger!

    30-50% under

    • Hong Kong
    • China
    • Malaysia
    • Thailand
    • Philippines
    • Russia
    • Indonesia
    • Taiwan

    0-30% under

    • Mexico
    • South Africa
    • Poland
    • South Korea
    • Singapore
    • Hungary
    • Chile
    • Argentina Czech rep
    • Britain
    • Peru

    0-13% over

    • Turkey
    • New Zealand
    • Japan
    • Canada

    The Australian Dollar is now 16% overvalued compared to the 40% undervaluation in October 2008. Hong Kong and China are still nearly 50% undervalued. The Euro, Canadian Dollar and the Australian Dollar are all 10-20% overvalued with the Yen at around purchasing power parity.

    An Insurance Trade

    The Australian dollar has an excellent track record of falling to greatly undervalued levels in times of crisis. This is very supportive of insurance trades from current AUDUSD levels. The table below shows the AUD P&L for shorting a hypothetical US index in USD where your record currency is AUD. The trade is

    1. Short Index
    2. Receive USD Cash
    3. Buy back index
    4. Convert USD Profit or Loss in to AUD

















    In the case where global markets fall and the AUD falls your gains are magnified. In the case where the AUD keeps rising and the US market keeps rising the losses are diminished. The risk in this trade is where a very country specific event happens to Australia causing the AUDUSD to fall and the US market still has a substantial rise. In that case your losses are magnified. Of all the cases, this one is relatively unlikely and as an insurance trade there is potential for the losses to be offset by your gains. I'm not proposing this is a great outright trade, only that it’s great insurance with a free kicker that grows when you most need it.

    Hong Kong Dollar

    Jim Grant has an excellent discussion of opportunities in Asian currencies and especially ways to profit from an eventual rise in the HKD, in his free summer break Vacation Delectation from August 2010, under the heading “Three-dollar tale”.

    “In preview we expect the Singapore dollar to appreciate and the Hong Kong dollar to appreciate-or, just possibly, to depreciate. Holding a certain kind of currency option, one would be paid in either case”.

    “Or taking an agnostic view you could buy a strangle with strikes set 10% out of the money on either side,…, two years out for 33 basis points”.

    Jim has done a better job than I ever could describing the situation and the trade he proposes has an excellent risk reward. I favour a substantial appreciation of the HKD over time but as both Jim Rogers and Jim Grant point out, the short term direction, on revaluation, could go anywhere. I wrote about REIT investments in Singapore and Hong Kong in July 2008. I made some investments and the subsequent drop in the AUD diminished the losses. Prosperity REIT was trading at HKD 1.5 in July 2008 when I wrote about it or .20 AUD (AUDHKD 7.50). By January 5th 2009 it was trading at 97c or 18c AUD (AUDHKD 5.50). The loss in HKD was 35%, in AUD only 10%. It closed today at 1.79 HKD and has paid 5 dividends totalling .30 since for a total return of 40% in HKD – not bad for a REIT (current AUDHKD is 7.74 so the AUD returns are 35% or 15% annualized). Receiving 15% a year while you wait for a revaluation isn’t bad but Jim’s trade is $0.33 to make $40 best case, if PPP is reached within 2 years!

    Portfolios with AUD (CAD or EUR) base currency

    This is a sound time to investing in USD assets and an excellent time to invest in HKD denominated assets. Cheap assets, of course, as always! With the HKD you get all the insurance benefits of a USD investment and the potential upside of a currency revaluation. It’s also a good time to re-orient portfolios out of your home country because the headwinds have moved there. This applies to the Australian Dollar, Canadian dollar and to a lesser extent the Euro.

    "The risk in this trade is where a very country specific event happens to Australia causing the AUDUSD to fall and the US market still has a substantial rise. In that case your losses are magnified. Of all the cases, this one is relatively unlikely and as an insurance trade there is potential for the losses to be offset by your gains."

    So unlucky with the flooding over there!
    "So unlucky with the flooding over there!"

    Well... The AUSUSD has hardly moved. This is not the sort of event that I was referring to. More like a banking crisis, credit crisis type thing. Stocks in Australia have been doing great and the currency has hardly moved.
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    Disclaimer and Disclosure Analyses are prepared from sources and data believed to be reliable, but no representation is made as to their accuracy or completeness. I am not paid by covered companies. Strategies or ideas are presented for informational purposes and should not be used as a basis for any financial decisions.
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